How Google Apps Could Cost Microsoft Up to $18 Billion in Value

Includes: GOOG, MSFT
by: TMT Analyst

Gauging the Financial Impact of Free Microsoft Office

Responding to Google’s (NASDAQ:GOOG) competitive threat on its cash cow, Microsoft (NASDAQ:MSFT) decided to offer free web versions of its MS Office, either through an online version similar to Google Apps, or a pc based edition pre-installed in PCs through the OEMs. The free offering is likely to be ad supported. Microsoft has already offered ad supported versions of Microsoft Works in certain countries and is likely to build off that practice with the free online versions.

The ad based version could be supported by display and search ads and should have ready access to Bing throughout the applications.

Microsoft’s CEO contends that any free offering is aimed at steaming the piracy impact rather than defending its turf against Google. I disagree, while acknowledging this effort’s part in monetizing pirated users.

The particular business under threat is Microsoft Business Division (MBD), which accounted for 30% of revenues in fiscal 2008 and has extremely high margins. [See a previous analysis of Microsoft’s revenue breakout.] Even more specifically, Microsoft Office, which is housed in MBD, accounted for 75% of MBD revenues. Drilling down further, the consumer segment of Microsoft Office, which I believe is the most exposed to Google Apps and, accounted for 20% of MBD revenues. Therefore, only 6% of Microsoft’s total revenues is under threat from Google Apps. Small, but significant nonetheless, given the high cash flow contribution from those revenues. I believe that there are little costs, if any, associated with the consumer division, so close to 100% of every dollar in this segment drops to the bottom line. I believe that Microsoft will find a way to exclude business users from using the free version or make it prohibitively expensive.

So what’s the financial impact to Microsoft from a free ad supported model? As I noted above, the consumer segment is the unit that’s actually under threat and that unit generated $3.8 billion in revenues in fiscal year 2008, with profits slightly below that figure. Let’s assume revenue growth is flat in fiscal year 2009 that ended in June. So that’s the base level of profits under threat.

But wait. Under 50% of those revenues are derived from retail sales, lets say 45%, with the remainder derived from PC OEMs. Cannibalization is important in my analysis, which I believe will only apply to the retail version, for now, but will likely impact the OEM revenues as time passes. So we are now down to $1.7 billion of revenues that is actually under threat.

Let's assume that 25% of potential retail users (and revenues) initially switch to the free online version. That number will likely prove conservative as time passes and I think should approach 100% in a few years but let’s stay with it now. So we are down to $430 million is revenues that is potentially lost.

I argued that consumer revenues are 100% incremental margins since any costs of development, support, and marketing are likely applied to the business version. But let's assume some costs - 5% of revenues. Applying Microsoft’s 26% tax rate will lead to $300 million in lost profits or $0.03 per share. For reference, the Wall Street consensus estimate is $1.65 per share for fiscal year 2009.

Microsoft can then generate about a $2.50 CPM for display ads on the free version. Let’s ignore potential search revenues for now. Based on page view estimates, I believe that Microsoft can generate approximately $100 million in revenues annually from advertising. This partially offsets the $430 million loss revenue estimate bringing the total lost revenues from the free online version to $330 million.

Assuming a 75% contribution margin on the display business, accounting for ad networks, ad agencies, etc., the loss estimate reduces from $330 million to $245 million or closer to $0.02 per share.

So the initial impact is a loss of 2 cents per share.

If we assume 100% of the retail business converts to the free version, then the impact is a $1.5 billion loss to profits or $0.13 per share, after accounting for the advertising revenues. This equates to an 8% negative EPS impact. That 8% negative impact equates to about $2 per Microsoft share (15x multiple to the 13 cents). The share price didn’t budge on the news, which leads me to believe that investors haven’t walked through the analysis or that the negative implication was already priced into the shares.

Either way, Google has cost Microsoft about $2 per share in value or $18 billion at the most aggressive of assumptions, or $0.30 per share on my initial analysis of a loss of 2 cents a share. Score one for Google. Now it is Microsoft’s turn to B(r)ing it.